The Color of Money

Well, we now know that Ben Bernanke is a man of his word. When the Fed suggested back in January that it would buy long-dated Treasurys, a lot of people just assumed it was a ploy to spook investors into re-directing capital out of the Treasury bond market and into riskier forays such as corporate bonds. Then Wednesday's statement from the FOMC came, revealing that the Federal Reserve fully intends to ramp up quantitative easing (AKA: firing up the printing presses) just as it said it would. Among the newest features are: purchases of up to an additional $750 billion-with a b-in Mortgage Backed Securities (MBS) from Fannie and Freddie, another $100 billion in agency debt, as well as up to $300 billion in 2- through 10-year dated Treasury securities. All told, this puts another $1.15 trillion on the Fed's multi-trillion dollar balance sheet.

These latest moves by the central bank may prove effective in greasing the economy's wheels in the near term; unfortunately, collateral damage is a serious risk from a longer-term perspective. Specifically, it appears the Fed's plan to combat deflation is to monetize the debt (or reflation as some have put it) through its purchases of debt instruments such as agency debt, MBS and Treasurys. According to the Fed, monetizing the debt might not necessarily be a bad thing at a time when money velocity is slower than a glacier and the U.S. dollar is serving as a global safe haven. Herein lies the problem-what happens when conditions change? For one, the Fed has to identify the right time and place in which it can reabsorb the vast liquidity it has injected into the economy without triggering a recessionary relapse. By contrast, act too late and risk creating an environment of soaring inflationary expectations and a stampede away from the dollar. No sweat, right?